Understanding The Modi Government’s ‘Angel Tax’ Controversy

One reason why Narendra Modi won the massive mandate in 2014 was that he had convinced India’s young that he was going to help them fulfil their dreams of becoming entrepreneurs. His motto of ‘minimum government, maximum governance’ stood for those values of creating an atmosphere that would unleash private animal spirits.

But four years down the line, it’s tougher for young people trying to start their own businesses. Hundreds of startups have been served notices under a section of the Income Tax Act which has come to be known as the ‘Angel Tax’. The tax, under section 56(2)(viib), was introduced by the UPA government in 2012 to fight money laundering. The stated rationale was that bribes and commissions could be disguised as angel investments to escape taxes. But given the possibility of this section being used to harass genuine startups, it was rarely invoked.

What does the section say? If a company has issued shares to an angel investor at a price that’s higher than its fair market value, the extra amount received by the company will be taxed at 30.9%. Let’s take an example to understand this. If a company’s shares are valued at Rs. 100 each, and it sells them to an angel investor at Rs. 120, the additional Rs. 20 would be treated as its income and not an investment. The company would then have to pay income tax on that extra Rs. 20 along with any additional fines that the IT department might impose for the company trying to disguise the income as investment.

On paper, this may appear justifiable. But the trouble is that the taxman is often unable to understand how startups are valued and how quickly those valuations can change. Startups, typically, begin with an innovative idea for a business and look for ‘angels’ – those who spot potential in an idea and invest in a company in its early phase. Again, typically, start-ups burn cash quickly, and over the first few years have to depend on several such angel investors. Depending on how the business is working, each subsequent angel investor comes in at a different valuation. Everyone in the investment businesses knows that such valuations are subjective and fickle.

It is easy, and tempting, for the IT department to dismiss them and select the lowest (or original valuation) as ‘fair market price’. This automatically leads to unfair tax demands and startups squander valuable time and money in challenging the IT notices. Startups are complaining that they are being forced to pay 20% of the total tax demand to even begin the appeals process. And given that some of the tax notices apply to as much as half the money given by angel investors, 20% of that is so substantial that it can leave the startup wiped out of funds. The startup is dead.

Some startups have even got tax demands because their companies have become less valuable. To understand this bizarre situation, imagine a company that has raised money in two rounds. In the first round, it raised Rs. 1 crore by selling 10% stake. After that, business conditions worsened, and competition increased. Now, when it tried to raise money again, it had to give up 12.5% stake for the same Rs. 1 crore (because its valuation had fallen). In other words, in Round 1, the company got Rs. 10 lakh for each 1% stake it sold, while in Round 2, it got only Rs. 8 lakh for the same amount of shares.

Now the IT department decides to treat the valuation of Round 2 as ‘fair market price’ and assesses that the company should have received only Rs. 80 lakh for the 10% stake it sold in Round 1, instead of the Rs. 1 crore it got. The Rs. 20 lakh difference would be treated as taxable income. And, because, in the IT department’s view, that tax ought to have been paid during Round 1, a fine would also be levied on the company. Imagine the startup’s plight if it is asked to cough up Rs. 10 lakh in prior taxes and fines right at a time when its valuation has gone down in the market.

Another set of notices have gone out under section 142(1). This section empowers tax officials to ask for the tax returns, creditworthiness, bank details and correspondence of angel investors who have put money in a startup. On the face of it, this section is meant to separate money launderers from genuine angel investors. However, the sudden demand for additional documents increases compliance costs for startups, who are usually struggling with finance and time.

Startups have been asked to register with the Department of Industrial Policy & Promotion (DIPP) to avoid getting such tax demands. However, only those companies which are less than seven years old, have never had an annual turnover of more than Rs. 25 crore and did not get more than 10 crores in total from angel investors qualify as startups. This means that startups who have done well in any one year in the past seven are automatically disqualified. Media reports suggest even startups who are registered with DIPP have received notices.

It is now widely accepted that the Modi government has failed on the job front. That is one reason for the electoral setbacks it has faced in assembly elections in the past one year. It is understandable that the government is desperate for more funds to spend on job creation in the months ahead of the Lok Sabha elections. Extracting more taxes wherever possible is one such way to raise finances. But to target startups is going to be counter-productive. After all, the startup ecosystem – from e-commerce firms to food delivery apps – has been the one outlier where thousands of new jobs have been created.